Summer 2018 examination

EC202
Microeconomic Principles II

2017/8 syllabus only – not for resit candidates

Instructions to candidates

This paper contains TWO sections. Section A is worth 40 marks, and Section B is worth 60 marks. Answer
ALL questions.

Time Allowed Reading Time: 15 minutes

Writing Time: 3 hours

You are supplied with: No additional materials

You may also use: No additional materials

Calculators: Calculators are not allowed in this examination

 LSE ST 2018/EC202 Page 1 of 5

 SECTION A: Section A is worth 40 marks.
1. In an uncertain world people have preferences represented by the function −αy0−γ − βy1−γ , where yi is the
payoff in state i = 0, 1 and α, β, γ are positive parameters.

(a) How can one use this formulation to depict differing degrees of risk aversion between people? [2 marks]
(b) How can one depict the possibility that people may have different subjective probabilities for states 0
and 1? [3 marks]
2. Which of the following statements is right? If a statement is wrong, how is it wrong?

(a) “In a given economy, any Pareto-efficient allocation must be superior to any Pareto-inefficient alloca-
tion.” [1 mark]
(b) “A competitive equilibrium might not be Pareto Efficient.” [1 mark]
(c) “A competitive-equilibrium allocation can never be a fair allocation.” [1 mark]
(d) “Deadweight loss from a commodity tax is likely to be large if the demand for the good is inelastic.” [2
marks]

3. Consider the following normal form game.

1/2 L C R
U 3, 1 1, 0 2, −1
M 2, −1 0, 11 3, 10
D 3, 2 1, 1 4, −2

(a) What strategies are strictly dominated? [1 mark]

(b) What strategies are weakly dominated? [2 mark]
(c) What strategies survive iterated deletion of strictly dominated strategies? [2 mark]
4. Consider the extensive form game indicated below.

(a) What are the Pure Strategy Nash Equilibria of this game? [2 marks]
(b) What are the Subgame Perfect Equilibria of this game? [3 marks]

 LSE ST 2018/EC202 Page 2 of 5

 5. Consider two players who play the following stage game for infinite repetitions:

1/2 H M L
H 8, 8 −2, −12 2, 10
M −12, −2 −2, 0 0, −2
L 10, 2 0, −2 −2, 0

Players maximize discount expected utility with discount factor δ.

(a) Find all pure strategy Nash equilibria for the stage game. [2 marks]
(b) Suppose that both players adopt the strategy “play H if every one played H at every point in the past,
and to mix between M and L with equal probability otherwise”. Show that this strategy is a Nash
equilibrium when δ = .9 but not Subgame Perfect. [3 marks]

6. A village consists of three villagers. They want to build a well. Each of them can build the well on her own,
and any who do the building incur a cost of 4 util. If at least one well is built, every villagers receives a
benefit of 9 utils. If not built, each gets a utility of zero. They decide simultaneously whether to build the
well.
(a) Find a symmetric, mixed strategy Nash equilibrium of this game. [3 marks]
(b) What is the probability of the well getting built? [2 marks]
model. A worker’s type is t ∈ {4, 9}. The probability that t = 4 is equal to 1/2.
7. Consider Spence’s signalling √
The firm obtains a profit of t − w(e) if she hires the worker who gets education e and zero if she does not
hire anyone. The cost to a worker of type t to obtain education e is C(e, t) = e2 /t.
(a) Find a pooling Perfect Bayesian Equilibrium where the firm makes zero profit and the worker gets
hired. [3 marks]
(b) Find a separating Perfect Bayesian Equilibrium where the firm makes zero profit and the worker gets
hired. [2 marks]
8. Consider a Principal agent problem with two possible effort levels e ∈ {H, L}. Output is zero for sure if the
agent exerts effort L, and equals 9 with probability p = 1/2 and 0 with probability 1 − p = 1/2 when the
agent exerts effort H. The agents utility is √
w − ce
when she receives wage w and exerts effort e, where cL = 0 and cH = 1. The principal is risk neutral and
maximizes expected profit. The principal must set positive wages.
(a) Derive the optimal wage schedule and principal’s expected profit when both output and effort are
observable. [2 marks]
(b) Derive the optimal wage schedule and principal’s expected profit when only output is observable.
[3 marks]

 LSE ST 2018/EC202 Page 3 of 5

SECTION B: Section B is worth 60 marks.
1. In a two-good exchange economy there are N people of type a who have preferences given by log(xa1 ) +
1 a 1 b b h
2 log(x2 ) and N people of type b people with preferences given by 2 log(x1 ) + log(x2 ), where xi is type h’s
consumption of good i. There are fixed total amounts (3N, 7N ) of the two goods available: each a type is
endowed with an amount (`, k) of goods 1 and 2; each b type is endowed with (3 − `, 7 − k) where 0 ≤ ` ≤ 3.
and 0 ≤ k ≤ 7 It is possible to carry out lump-sum transfers of commodity 2 (k can be varied), but impossible
to transfer commodity 1 (` is fixed).

(a) Find the competitive equilibrium price of good 1 in terms of good 2, given a particular value of (`, k)
and show that individuals’ incomes (y a , y b ) in equilibrium are given by

7` + 6k
ya = ,
6−`
63 − 14` − 3k
yb = .
6−`
[5 marks]
(b) Draw a diagram of the set of attainable income distributions (i) in the case where ` = 0; (ii) in the case
where ` = 3. [5 marks]
(c) The government seeks to maximise the welfare function y a +y b . What would be the optimal distribution
of income in each of the two cases ` = 0, ` = 3? [5 marks]

(d) Suppose a new government seeks to maximise the welfare function min y a , y b What would be the
optimal distribution of income in each of the two cases ` = 0, ` = 3? Compare your results to part (c).
[5 marks]

2. Two players play the following game. Player 1 chooses between actions {A, B} while player 2 chooses between
actions {X, Y, Z}. The payoffs are described by

1/2 X Y Z
A 3, 1 2, 2 0, 0
B 0, 0 2, 2 1, 3

(a) Find all the pure strategy Nash Equilibria of this game. [4 marks]
(b) Find all the mixed strategy Nash Equilibria of this game. [3 marks]
Now, player 1 moves first and chooses {A, B}. Player 2 observes Player 1’s action choice before choosing
{X, Y, Z}. Payoffs are as above.
(c) Formulate this siutation as an extensive form game. [3 marks]
(d) What is the normal form associated with this extensive form game? [3 marks]
(e) Find all pure strategy Nash equilibria of the extensive form game. [3 marks]
(f) Find all Subgame Perfect equilbria of the extensive form game. [4 marks]

 LSE ST 2018/EC202 Page 4 of 5

 3. A risk-neutral firm provides a service to a group of customers. Each customer either buys zero or exactly
one unit of the service; as a service, it cannot be divided or resold. However, customers differ in the difficulty
of being served. The difficulty is characterised by a non-negative number d. The cost of producing one unit
of good at difficulty d is d, so the profit of selling the service for price p to customer d is

π(p, d) = p − d.

A customer of difficulty d is willing to pay θ(d) = 2d − 1 for the service, so her utility from paying p to
receive the service is
Ud (p) = θ(d) − p.
The customer knows how difficult she is to serve.
(a) Suppose that there is a single customer, and that the firm also knows d. If the firm makes a “take-it-
or-leave-it” offer to the customer for the service, what offer does she make (as a function of d) in a
Subgame Perfect Equilibrium and how much profit does she receive? [4 marks]
(b) Suppose that there is a single customer, and only the customer knows d. If dl = 89 and dh = 32 are
equally likely and the firm makes a “take-it-or-leave-it” offer to the customer for providing the
service, what offer does she makein a Subgame Perfect Equilibrium and how much profit does she
receive? [4 marks]
(c) Suppose that there is a single customer, only the customer knows d, and d is distributed uniformly on
[1, 2], that is the probability that d is less than x ∈ [1, 2] is x − 1. If the firm makes a “take-it-or-
leave-it” offer of p ∈ [1, 3] to the customer for the service, what is the expected cost of the customers
who accept? [4 marks]
(d) Suppose that there is a single customer, only the customer knows d, and d is distributed uniformly on
[1, 2]. If the firm makes a “take-it-or-leave-it” offer, what offer does she make (as a function of d)
in a Subgame Perfect Equilibrium and how much profit does she receive? [4 marks]
(e) Suppose now that there are infinitely many customers with total mass 1, and the fraction of customers
with d < x is x − 1 for any x ∈ [1, 2] (note d is distributed as in parts c and d). The market changes so
that additional firms can freely enter. Is there a perfectly competitive equilibrium? If so, what is
it? If not, why not? [4 marks]

 LSE ST 2018/EC202 Page 5 of 5